I read two interesting pieces this weekend that have convinced me that we, at Finteum, and everyone else that is working on changing financial services for the better have a long road ahead. One piece was Mark Carney’s speech at Jackson Hole about the future of financial market infrastructure as a support for monetary policy. The other piece was a post from Baringa Partners about the UK National Grid issue on 9 August.
You might ask, is there is a valuable comparison between financial market infrastructure (FMI) and the electricity grid. The similarity is that both perform an important function for modern society. When FMI stops working, people can’t pay for things. When electricity stops working, people can’t do everyday things, such as commuting. However, there are two important contrasts between FMI and electricity — (1) preparation and (2) redundancy, which I explain below, before finishing with some comments on digital currencies.
Carney called this “re-building an adequate global financial safety net” and it is his medium-term goal for central bankers.
In the electricity National Grid, the users are prepared. Organisations, like hospitals, build regulatory-compliant backup generators that kick in automatically when the grid fails. Organisations can’t put a nuclear generator in the basement, but are encouraged to be prepared so that people can still receive essential services.
In FMI, the users (mostly banks) have very little influence when FMI fails. Banks don’t have the FMI equivalent of backup generators. When FMI fails, there is no backup system in banks’ control that kicks in automatically and enables them to continue providing essential services. Sometimes there are workaround solutions, but often not. As Carney mentioned, the financial system has been made safer with more capital and liquidity and with better controls. He is correct that the BoE has “transformed the resiliency of UK-based banks”. Somewhat unfairly, banks need to hold liquidity buffers and put staff in specific functions, legal entities and locations to be prepared to cope with FMI failures, but banks are not empowered to influence such situations when they arise. Sometimes banks are shareholders in FMI organisations, but that is very different to banks having direct control over a regulatory-approved backup FMI system that kicks in automatically.
Redundancy means we should avoid dependency in FMI. Carney said we should “think through every opportunity, including those presented by new technologies, to create a more balanced and effective system” and it is his long-term goal for central bankers.
In the National Grid, there are electricity providers that are redundant. On 9 August it took less than 10 minutes between the massive solar and diesel generators failing and the replacement power coming online.
Compare that to the situation in FMI. In FMI there are backup plans and backup servers, but no redundancy. The Australian infrastructure is more advanced than most economies, and the central bank (RBA) should be commended for their transparency on this issue. In August 2018 it took three hours to reboot when their system failed. If it had lasted longer, the impact would have been much worse. I have not yet seen a BIS or IMF comment yet on any self-assessment that central banks and FMIs are doing in the interim on lessons learned, and to check whether their services, processes and systems are as robust and resilient as people expect. Separate to individual FMI providers’ resiliency, centralised FMI makes sense most of the time, but I would argue that the BIS and IMF should review whether we need better backup plans and more redundancy for those centralised services. It is clear that electricity is streets ahead of FMI.
In Carney’s speech he expresses particular concern about the lack of redundancy, or the dependency, on the US Dollar. He highlights that there are risks around the potential transition to Renminbi as a global reserve currency. He suggests that technology could help to create a solution and suggests that a network of central bank digital currencies could help to create a multipolar system. I must say, I agree with him that a multipolar system would create benefits for the world economy.
However, Carney went on to suggest that central banks could create a single Synthetic Hegemony Currency (SHC), which is where I disagree. This SHC sounds remarkably similar to the IMF Special Drawing Rights (SDR). Maybe the rumour that Carney has his mind on the IMF top job influenced his thinking. His suggestion is the world might be better if “… the share of trade invoiced in SHC were to rise …” and “…if a financial architecture developed around the new SHC …” but I think he misses a vital point.
In fact, there is no technology constraint that prevents organisations and individuals from trading, invoicing and creating infrastructure around the existing IMF SDR. The main reason that they don’t do so, I suspect, is the same problem I expressed in this previous post about Facebook’s Libra (the post was before the official Libra announcement, so some of it is redundant but most is still valid). The SDR is not an effective means of exchange for organisations and individuals. People don’t want to be paid in SDR. You can’t pay your taxes in SDR. Some crypto enthusiasts are delighting about Carney’s speech, but crypto faces the same means of exchange issue. If Carney’s SHC was a great idea, the infrastructure he talks about would already exist because there is no barrier to creating it.
So what could a better multipolar system look like? One of the initiatives that we are working on quietly at Finteum goes to the heart of the matter — why do companies invoice in dollars? For example, why would an exporter in Kenya export to the EU and invoice in US dollars (USD) instead of Kenyan Shillings (KES) or Euro (EUR)? The answer is there are insufficient liquid and accessible direct pair financial markets between KES and EUR. If the exporter were to invoice in EUR, they would have to convert EUR into USD and then from USD into KES. The bid-ask spread on the direct EUR/KES pair that the exporter’s bank would quote makes it penal and inefficient to trade it. Maybe the exporter could use Transferwise, but not for a large amount.
At Finteum, we are working with partners and architecting tools that have the potential to increase liquidity in direct pair markets and to create a multi-polar system (we will announce more about that work closer to Sibos time in September). Market liquidity in traded pairs would inevitably still concentrate in major import/export currencies, but it would be an improvement to the current USD concentration. As Carney points out, the dollar “represents the currency of choice for at least half of international trade invoices, around five times greater than the US’s share in world goods imports, and three times its share in world exports”. Digital currencies that are regulated and linked to their central bank fiat equivalents have the potential to make such direct pair markets more efficient and effective. I believe this is preferable to a concentration in USD.
I believe it is also preferable to a concentration in Carney’s SHC.